How does an ILIT handle a policy that is part of a split dollar arrangement

Lonnie called me last week, frantic. His wife, Carol, had unexpectedly passed, and he’d just discovered a critical flaw in the planning for their life insurance. They had a split-dollar policy with his business partner, and the portion of the death benefit payable to their family was supposed to be sheltered in an Irrevocable Life Insurance Trust (ILIT). But Carol, in a moment of confusion during a hospital stay, had signed a revised trust document – a codicil – that inadvertently gave her the power to revoke the trust and reclaim the policy. The insurance company is refusing to pay the death benefit into the ILIT, and Lonnie is facing a potential six-figure tax bill. This is, sadly, a common situation, and highlights the absolute necessity of meticulous ILIT administration.

What is a Split Dollar Arrangement?

A split-dollar life insurance agreement is a financial arrangement between an employer and an employee, or between two individuals, where the costs and benefits of a life insurance policy are shared. Typically, one party (the “policy owner”) pays the premiums, and the other party (the “insured”) receives the death benefit, or a portion thereof. These arrangements are often used for executive compensation, estate planning, or funding buy-sell agreements. The key is that ownership – and the incident of ownership – is crucial.

How Does an ILIT Fit In?

When a split-dollar policy is involved, integrating the policy into an ILIT requires careful coordination. The ILIT’s primary function remains the same: to remove the policy’s death benefit from your taxable estate. However, the split-dollar agreement complicates matters because it introduces another layer of ownership and benefit allocation. The ILIT does not own the policy directly; rather, it’s designed to receive the portion of the death benefit allocated to your family or designated beneficiaries under the split-dollar agreement.

Key Considerations for Split Dollar Policies & ILITs

Several factors must be addressed when establishing an ILIT to receive split-dollar benefits:

• Ownership & Control: The split-dollar agreement must clearly define who owns the policy and who controls it. The grantor of the ILIT (the person establishing the trust) cannot be the policy owner or have any ‘incidents of ownership’ that would cause the death benefit to be included in their estate. This is governed by Incidents of Ownership (IRC § 2042). The ILIT is essentially a third-party beneficiary, relying on the split-dollar contract to dictate the flow of funds.
• Premium Payments: If you, as the grantor, continue to pay the premiums on the policy, even though it’s part of a split-dollar arrangement, those payments must still be structured as gifts to the ILIT to qualify for the annual gift tax exclusion. The trustee must send ‘Crummey Letters’ to beneficiaries every time a deposit is made, granting them a temporary right to withdraw the funds (typically for 30 days) as outlined in IRC § 2503(b).
• Beneficiary Designations: The ILIT should be named as the secondary beneficiary for the portion of the death benefit allocated under the split-dollar agreement. The primary beneficiary will typically be the business partner or the employer. This ensures that the ILIT receives the intended proceeds after the primary beneficiary’s needs are met.
• Tax Implications: Split-dollar agreements have their own unique tax implications, separate from the estate tax avoidance benefits of an ILIT. The arrangement must be carefully structured to avoid triggering immediate income tax consequences.

The “Clawback” Problem with Existing Policies

If you are transferring an existing split-dollar policy into an ILIT, be extraordinarily careful. Under IRC § 2035, if you transfer an existing life insurance policy into an ILIT and pass away within 3 years, the death benefit is ‘clawed back’ into your taxable estate. This applies equally to split-dollar situations. The ILIT should ideally purchase the policy directly from the start to avoid this issue.

After 35+ years as both an Estate Planning Attorney and a Certified Public Accountant, I’ve seen firsthand the immense value of proactive planning. The CPA perspective is critical here. Properly structured, life insurance can provide a significant step-up in basis for assets transferred to your heirs, minimizing capital gains taxes. We consider the policy’s cost basis, valuation nuances, and potential impact on overall estate tax liability when creating the ILIT.

Digital Access & Policy Management

Don’t overlook the practical aspects of accessing and managing the policy. Without specific RUFADAA language (Probate Code § 870) in the ILIT, service providers and insurers can legally block your trustee from accessing online policy portals to manage premiums or file claims. This could create significant delays and complications when a claim needs to be filed.

What Happens if Assets are Missed? (Premium Refunds/Cash)

Sometimes, despite best efforts, cash assets intended for the ILIT end up legally remaining in the grantor’s name. For deaths on or after April 1, 2025, if those cash assets (valued up to $750,000) remain in the grantor’s name, they can qualify for a ‘Petition for Succession’ under AB 2016 (Probate Code § 13151). This allows a court order to direct those assets to the ILIT. It’s crucial to understand that this is a ‘Petition’ (requiring a Judge’s Order), not an ‘Affidavit.’ A Small Estate Affidavit is not sufficient for this purpose.

What causes California trust administration to fail due to poor funding, vague terms, or trustee misconduct?

California trusts are designed to bypass probate and maintain privacy, yet they often fail when assets are not properly funded, trustee duties are ignored, or ambiguous terms trigger disputes. Even with a signed trust document, families can face court battles if the “operations manual” of the trust isn’t followed strictly under the Probate Code.

• Validation: Verify assets via trust asset schedules.
• Contests: Handle trustee defense immediately.
• Flexibility: Know when to use irrevocable trusts rules.

Ultimately, the success of a trust depends on the details—proper funding, clear terms, and a trustee willing to follow the rules. By anticipating friction points and documenting every step of the administration, fiduciaries can protect the estate and themselves from liability.

Verified Authority on ILIT Administration & Tax Compliance

• The “3-Year Rule” (IRC § 2035): Internal Revenue Code § 2035
  The critical statute warning that transferring an existing policy to an ILIT triggers a 3-year waiting period. If the grantor dies within this window, the insurance proceeds are pulled back into the taxable estate.
• Incidents of Ownership (IRC § 2042): Internal Revenue Code § 2042
  This code section defines why a grantor cannot be the trustee. Retaining the power to change beneficiaries or borrow against the policy forces the death benefit into the gross estate for tax purposes.
• Annual Gift Exclusion (Crummey Powers): IRS Gift Tax Guidelines (IRC § 2503)
  The legal basis for “Crummey Letters.” Without these withdrawal notices, money contributed to the ILIT to pay premiums does not qualify for the annual gift tax exclusion and eats into the lifetime exemption.
• Federal Estate Tax Exemption: IRS Estate Tax Guidelines
  Reflects the permanent increase to a $15 million per person exemption (effective Jan 1, 2026). ILITs remain the primary vehicle for ensuring life insurance proceeds sit on top of this exemption rather than consuming it.
• Missed Asset Recovery (Small Estate): California Probate Code § 13100 (Affidavit)
  If “unspent premiums” or refund checks intended for the ILIT were accidentally left in the grantor’s name, you must use the Small Estate Affidavit to collect them. Note that for deaths on or after April 1, 2025, the total value of these cash assets cannot exceed $208,850 to avoid full probate.
• Digital Policy Access (RUFADAA): California Probate Code § 870 (RUFADAA)
  Without RUFADAA powers, a trustee may be unable to access online insurance dashboards to verify premium payments, potentially causing the policy to lapse.